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Class 12 &quot;and 15&quot; Completed

# K so in any given year the actual ex post real rate

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K So in any given year, the actual (ex-post) real rate of return will be different from the ex-ante expected real rate of return. – Which is OK as long as on average, there is no bias towards either over- or underestimating inflation so that over longer time horizons, ex- ante and ex-post real returns are the same.

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Mommy, Mommy, Where Do Interest Rates Come From? K The Bank of Canada determines very short term interest rates through its influence on the overnight rate – This is the rate at which banks can borrow cash reserves on an overnight basis . K All other interest rates are determined by market forces. – Where supply of lending matches demand for borrowing. K Term Structure of Interest Rates: – Different markets for different terms to maturity. » Yield curve. » Zero-coupon government bond yield curve K Different markets for different risk types. – Government vs. corporate bonds 11
12 The Term Structure of Interest Rates and the Yield Curve K When we calculated the present value of an annuity using the PV Annuity Formula, we assumed that we could apply the same interest rate to all future annuity payments, whether they were one year from now or 30 years from now. K When you look at interest rates that banks offer on financial investments or charge for loans, you will notice that they depend on the horizon (or term ) of the investment or loan. – For example, the yield-to-maturity for a 1-year zero-coupon Government Bond is different from the yield-to-maturity for a 30-year zero-coupon Government Bond. K Think about the risk of a 30-year bond compared to a 1-year bond. K The relationship between the investment term (time to maturity) and the interest rate on zero-coupon Government bonds is called the Term Structure of Interest Rates . K The graphical representation of the term structure is called the Yield Curve .

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13 How to Dismantle a Yield Curve K What accounts for the fact that the shape of the yield curve changes all the time? K For a zero-coupon government bond yield curve, there are three components: – The real interest rate K The return investors require to save or invest their money instead of consuming it. Often assumed to be constant for all maturities. K Can change over time, though. This would effect the level of interest rates but not the slope of the yield curve. – An interest rate risk premium
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K So in any given year the actual ex post real rate of...

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